So far the potential trade war hasn’t had much of an effect on the Fed Funds futures, which are handicapping a 86% chance of a hike in May and have centered on 3 hikes for the full year. The impact of a trade war will be an interesting question for the Fed. On one hand, they raise prices, which should translate into higher inflation. On the other, they depress economic activity which should translate into slower growth and higher unemployment. The first effect is more near term, while the second order effect is longer-term.

Bolstering the Administration’s case for tariffs is the fact that the trade deficit rose to a 9 year high last month.

Atlanta Fed President Raphael Bostic says that the Fed should take a “wait and see” approach to a trade war. While the Trump Administration may be pushing back from globalization, Congress has not, and the courts provide another speed bump to tariffs. Note as well, that the US “ask” in trade negotiations usually centers on intellectual property protection, and that means Hollywood and Big Tech. Their partisanship will probably come back to haunt them. Think Trump is going to care about the Chinese pirating the latest Michael Moore flick? Or the latest left-wing Netflix “documentary?”

The economy added 235,000 jobs in February, according to the ADP Employment survey. The Street is looking for 205,000 jobs in Friday’s jobs report. The ADP report has been coming in higher than the BLS reports lately, so this should have a muted effect. Secondly, the focus on the jobs report (at least from the Street’s perspective) has shifted from payroll growth to wage inflation.

Mortgage Applications rose 0.3% last week as purchases fell 1% and refis rose 2%. The average 30 year mortgage rate rose 1 basis point to 4.65%, the highest since early 2014.

Nonfarm productivity for the fourth quarter was revised upward to flat, while unit labor costs were revised upward to 2.5% from 2.0%. Compensation costs drove the increase. So far, companies have been unable to pass on higher costs in the form of higher prices, which should mean profit margins will come in, making stocks vulnerable. This should translate into lower interest rates at the margin.

A real estate startup called Knock is looking to disrupt the real estate industry by acting as a market maker for homes. They will buy a seller’s home, move them into a new one, and then sell the old home. The benefit for the home seller is that they will now be able to compete in bidding wars without having any sort of home sale contingencies. That said, this is clearly a bull market phenomenon, and in this market the tough part is not selling your current house – it is getting (and winning) your new one. Still an interesting idea.

Stocks are higher this morning on no real news. Bonds and MBS are down.

The EU proposed tariffs on some US goods if Trump follows through on his plan to institute higher tariffs on steel and aluminum imports. White House Gary Cohn is working with business leaders in an attempt to change the President’s mind. Think about that. An economic advisor is reaching out to administration outsiders to try and get the President to change his mind. Imagine Austan Goolsbee soliciting the input of the financial industry in 2009 in an effort to derail Dodd-Frank. Supposedly Cohn plans to resign if Trump doesn’t relent on a trade war. House Speaker Paul Ryan has also come out against tariffs. Despite Trump’s warning that he “won’t back down” on tariffs, the markets are starting to bet that a trade war isn’t going to happen, which is probably why futures are up.

Don’t forget that we already have tariffs on Canadian softwood lumber. Prices are at record levels. This is yet one more reason why we have such an affordability problem – not enough (cheap) new construction.

House prices rose 0.4% MOM from December to January, according to CoreLogic. Prices are up 6.6% YOY. They are forecasting prices to rise 5% this year. The fastest appreciation is at the lower price points, where prices are increasing 9% for homes at the 75% of the area’s median home price, while appreciating only 5% for homes at 125% of the area’s median home price. This demonstrates the struggle that the first time homebuyer is facing: rising rates and higher home price appreciation. Below is a chart of where home prices are overvalued and undervalued

Factory orders fell 1.4% in January reversing a string of gains. This is interesting simply because most of the regional Fed reports and the ISM data are showing strength in new orders, which was the weakness in this report.

Stocks are lower this morning the trade cold war between the US and the world escalated. Bonds and MBS are up.

Those hoping that Donald Trump would re-think his position on trade over the weekend were disappointed. He is now threatening EU automakers and demanding a re-negotiation of NAFTA to ease steel and aluminum restrictions with Mexico and Canada. Exiting and / or renegotiating NAFTA will probably not be as easy as he thinks it will be. The US has always had the leadership position globally in encouraging free trade. There is no doubt it that has accepted some protectionism from other countries as a cost of doing business, and in the spirit of moving the ball on free trade in general. In other words, the US has accepted a disadvantaged position, and these “free trade” agreements were in reality a negotiation over how many points the US would spot other countries.

Rates this week will be primarily determined by the fluid state of trade announcements. We will get some important market-moving data this week with the jobs report on Friday, and productivity on Wednesday. There will also be Fed-Speak all week.

Big picture, trade tensions are causing a flight to quality, which is pushing down interest rates. This is probably going to be only a temporary phenomenon so I would encourage LOs to push their customers to lock. Despite rising rates, we are not seeing an influx of foreign money into Treasuries, and we are seeing European investors and Japanese investors investing in Bunds and JGBs despite the lower yields. Why would investors accept 62 basis points in Germany or 5 basis points in Japan when they could get 2.8% in the US? Currency hedging costs wipe out the differential.

Trade battles are generally bad for everyone involved, except for domestic producers in the industries being protected. Note that Secretary of Commerce Wilbur Ross is an ex-steel guy himself and is not an idealistic free-trader. I suspect that is where Trump is getting his advice, although the media claims it was a petulant decision out of the blue as a result of negative headlines.

The services economy continues to expand, with the ISM Non-Manufacturing index hitting 59.5 in February. This was lower than the exceptionally strong January reading of 59.9. The internals of the report were good, with the New Orders and Employment indices coming in over 60. Some of the comments from business below:

“Lumber-related costs continue to increase as supply is also starting to become a problem. The market volatility of construction materials and the short supply of construction labor have added difficulty to long-term planning.” (Construction)

“Slight increase in activity; beginning to see some higher cost for goods and services.” (Finance & Insurance)

Stocks are lower this morning on news of a possible trade war. Bonds and MBS are flattish.

Donald Trump has announced plans to impose 25% tariffs on steel imports and 10% tariffs on aluminum imports. The dollar has weakened in response, and we have seen bond yields fall as well. He characterized trade wars as “good” and “easy to win.” As a general rule, nobody wins trade wars – they depress economic growth – but the silver lining is that you are seeing a bit of a flight to quality, which means Treasuries have a bid for once. This is pushing rates down. Don’t know how long it will last (he may be bluffing, or someone will probably talk him out of it), but take advantage of it. I could see him re-thinking and abandoning this idea over the weekend, and we could be looking at a 2.9% 10 year on Monday.

Consumer sentiment was flat in February, according to the University of Michigan Consumer Sentiment Survey.

Jerome Powell’s testimony in front of the Senate wasn’t all that dramatic. The main subjects were wage growth (or the lack of it), fair lending, and regulation. Elizabeth Warren spent her time harping on Wells Fargo. These events are mainly for political posturing and not much else. One Senator asked him about climate change, which Powell took in stride. I was hoping he would ask the Senator to lay out the connection between the Fed Funds rate and atmospheric CO2, but alas he played it straight.

On the subject of the labor market and wage growth, he said that nobody really knows what full employment actually is. The unemployment rate suggests that we are, while wage growth and the labor force participation rate suggest we are not. His view is that if you take all of the data, we are probably at or very close to full employment. He did say that the Fed has been modeling something like a 25 basis point annual decline in the labor force participation rate due to demographics – i.e. the retiring Baby Boomers, and that it has now caught up with that demographic model.

Acting Director of the CFPB Mick Mulvaney said yesterday that the Bureau will rely more on state AGs when deciding on enforcement actions. He reiterated the plan to spend resources on cases that are on “solid legal ground” and less on “creative claims.” Regulation by enforcement is also on the way out, and the CFPB intends to be much more forthcoming in telling the industry what the rules of the road are.

Jerome Powell is set to testify in front of the Senate this morning. On Tuesday, he made some hawkish statements about inflation that sent bond yields higher. I doubt we will see a repeat today, but just be aware.

Initial Jobless Claims fell to 210,000 last week, the lowest number since the 1960s. Last week included the President’s Day holiday, which means we could have some sort of funky adjustment going on, but regardless it speaks to a labor market where employers are hanging onto their employees.

Personal Incomes rose 0.4% last month, while consumer spending rose 0.2%. The incomes number was a little better than expected. The inflation numbers show a modest pickup, but the core annual growth came in at 1.5% YOY, which is below the Fed’s 2% target.

Construction spending came in flat for January, and is up 3.2% YOY. Residential Construction was up 0.2% MOM and rose 4.3% YOY.

“Availability of electronic components, long lead times, allocations and constraints continue to wreak havoc in the purchasing cycle, with no end in sight at this time.” (Computer & Electronic Products

“Steel market is doing rather well. Everybody is out of what I need.” (Fabricated Metal Products)

“Business is very strong, and our lines are running at full capacity.” (Plastics & Rubber Products)

All of these statements relate to demand-driven bottlenecks and point towards inflation going forward. In fact, an ISM reading of this level would normally correspond with GDP growth over 5%. Note that the Fed pays close attention to the ISM numbers.

Interesting development in the capital markets: Streaming music site Spotify is going public, without doing an IPO. Instead of selling a chunk of the company to an investment bank, who then sells it to the public, Spotify will skip the whole process and do a direct IPO, where it sells stock directly to the public on the NYSE. Without the certainty of a set number of shares, a set price for the shares and any sort of lock up period, SPOT could be a volatile stock out of the gate.

The Senate looks poised to tackle banking reform, which essentially eases some of the Dodd-Frank restrictions on smaller banks. The asset threshold will be moved from $50 billion in assets to $250 billion in assets, which will prevent banks like M&T or Zions from having to conduct the detailed, 20,000 page stress tests that the bigger banks have to do. Aside from a few on the far left, there is general bipartisan support for easing the regulatory burden on smaller banks.

Stocks are marginally higher this morning after the second revision to fourth quarter GDP came in as expected. Bonds and MBS are flat.

Fourth quarter GDP increased at 2.5%, which matched Street expectations. The price index was revised downward a touch and consumer spending was revised upward. For the year, GDP increased at 2.3% versus 1.6% for 2016. Inflation is picking up, as the price index rose 2.5% versus 1.7% in the third quarter. Excluding food and energy, the index was up 1.9%, compared to 1.3% in the third quarter.

The Chicago PMI decelerated last month, but still came in at a strong 61.9. The number was below estimates however.

Pending Home Sales fell 4.7% in January, according to NAR. This is down 3.8% YOY and the lowest since October 2014 after the Taper Tantrum. Despite higher rates and smaller inventory, traffic was up YOY in January, except for the Northeast, which could have been weather-driven.

Jerome Powell spooked the bond markets yesterday during his testimony in front of the House. He acknowledged that inflation is accelerating and that the economy has improved since the meeting in December, and that statement pushed bond yields higher. He said he didn’t want to “prejudge a new set of projections,” referring to the dot plot at the March meeting. Powell will testify in front of the Senate tomorrow.

The Fed Funds futures didn’t really do much in response: The March futures are now handicapping an 87% chance of a hike and the consensus is still for 3 hikes this year.

Mortgage applications increased 2.7% during the holiday-shortened week, with the refi index falling 1% and the purchase index increasing 6%. The average contract rate was 4.64%, unchanged from the prior week.

The NAR and ATTOM weigh in on the real estate outlook for 2018. Unsurprisingly, they expect the inventory issue to continue, and homebuilders to modestly ramp up production while constrained by labor shortages. They point out also that the churn of move-up buyers has largely collapsed post-crisis. The average tenure (or amount of time that someone has lived in their home) has doubled since the crisis, from just over 4 years to 8 years. This lack of churn depresses the number of homes available on the market. I wonder if the churn was simply an issue related to underwater homeowners – short sales are tough to do. Second, as the foreclosure inventory is largely worked through, with the exception of the Northeast and a few other states, distressed homes are drying up. I suspect the professional investors who bought these homes will want to ring the register at some point, but that will be a function of interest rates and home price appreciation.

Lowe’s missed Street estimates and is down 8% pre-open. It looks like this is a company-specific problem and doesn’t reflect on the home improvement market. The Despot beat earnings recently.

Home prices rose 6.3% YOY in December to close out 2017 up 6.3% overall. House price inflation will be subject to a bit of a push-pull effect: Strong demand and limited supply will provide support for home prices, while increasing interest rates will reduce affordability and should have a dampening effect on home price inflation. That said, by historical standards, these mortgage rates are still extremely low, and affordability is still extremely high, at least on a long-term basis when you use monthly payment as a percentage of income.

Fed Chairman Jerome Powell testifies in front of Congress this morning at 10:00 am. Here are his prepared remarks. Nothing in the remarks jumps out at me as anything all that new, although Powell argues that the stability of the labor force participation rate over the past few years is a sign of strength, not weakness. Yes, baby boomers are retiring but their kids are entering the workforce so it should balance out. Below is a chart of the labor force participation rate going back to WWII. Note the steady rise beginning in the 1960s. That is the baby boom entering the workforce, and the secular change of more women entering the workforce. About half of those gains have been given back in the Great Recession. I think he is saying that the labor force participation rate should be trending even lower due to demographic factors, and that the stability of the past few years is evidence that the labor market is strong. Perhaps.

The Fed has always had a simple model of unemployment and inflation called the Phillips Curve. It basically says that unemployment will start driving inflation if it gets low enough. Historically economists have thought that unemployment levels in the low 4s would trigger it. So far we have seen some wage inflation in some skilled areas, but nothing widespread. Most of the inflation we have been seeing has been commodity push inflation driven by food and energy prices. These things often reverse, as higher prices invite new supply. Or in other words, the cure for high prices is high prices.

You are beginning to see a new theory in academia – that the slow growth in wages is not due to a supply / demand issue, but is evidence of an antitrust problem, or at least a market failure. Hard to see how heavyweights like Wal Mart and McDonalds are colluding for low wage labor, but that;s what they believe, and they think the cure is a higher minimum wage, more unions, and exerting more oversight over the bigger employers. Occam’s Razor says that labor-replacing technology is probably the driver, but that’s no fun.